Tools to Raise Capital for Startups: EXPLAINED
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Hi, my name is Neil Fridman, Esq., Managing Partner of Fridman Law Firm. And today I want to discuss with you the different types of instruments for raising capital in the startup context. So first we have SAFE Notes. What is a SAFE? A SAFE is a simple agreement for future equity that was developed by Y Combinator to make it easy and simple to raise capital at an earlier stage and does not provide any sort of obligation on the founders to repay an interest after a certain maturity period. So this document was created to help provide clarity for founders without the obligation of having to repay the interest at maturity. Why do people use it? It’s increasingly used in Silicon Valley, and even more so now on the East Coast as well. It’s a very simple document. People understand it, sophisticated investors understand it, VC’s understand it. And it allows founders to kick the can down the road until they have more growth and their valuation has increased. And more importantly, the SAFE will not convert until the company has achieved or brought in capital from an equity financing from an institutional investor, such as a venture capital firm or private equity group.
The convertible note in contrast, which was used and still used in many contexts, is similar in that the founder would present this note to an investor and the investor would invest funds. There would be interest that would accrue on the note until a maturity date that’s set. It’s similar to the SAFE in that upon a financing event, the note would convert. Sometimes the financing event also coincides with an amount that needs to be raised, such as $1 million, so that you can continue to raise capital from other investors throughout this period without triggering the conversion. The important thing to know about the convertible note is that interest will accrue on the note and is due at a certain maturity. Now, holders of the note can choose to delay this should the startup not have that financing event or be able to repay the note at that time (and it could remain outstanding). But there is an inherent obligation to repay that. In contrast to the SAFE, which does not have that same obligation.
The third financing mechanism is the priced round, which is where the founders and the management team of your startup company would set a per share price on the stock or preferred shares of the company and sell that to investors. This provides the most clarity but it does not allow you to grow the company while this obligation remains outstanding. It’s an exchange of cash for equity at a certain price per share. Those are the differences.
You have the SAFE note, which the obligation to repay sits out there until this magical financing event. #2, you have the convertible note, which would convert either at a financing event or the interest would get repaid at maturity. And third, you have a priced round, which provides a definitive price per share that investors are investing in, similar to how you would invest in publicly traded markets. Thank you!
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